Gold Miners: Taking a Peek Under the Hood

You can tell that by watching the Gold Miners Ratio, a fraction that compares the relative weight of the Market Vectors Gold Miners ETF (NYSEARCA:GDX) to its younger sibling, the Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ).

The "senior" fund comprises 30 established gold producers, while the "junior" portfolio includes 60 issuers, mostly companies engaged in the exploration and development of gold properties.

The miners' ratio uses GDX's share price as its numerator, while the market value of GDXJ is the denominator. Presently, the ratio's in the 1.60 area, which is a historic low. Simply put, the price of the junior fund has been rising relative to the senior portfolio since July. Hence the risk.

Over the summer, investors, hoping for leveraged gains, were much more willing to suffer the vicissitudes of early-stage mining ventures. And why not? As illustrated in a previous article ("Are Gold Stocks Better For Your Portfolio?"), the junior fund handily outperformed the producer portfolio and even the price of bullion itself this year.

Gold Miners Ratio (GDX/GDXJ)

That doesn't necessarily mean the GDXJ portfolio was the best way for investors to obtain gold exposure. In fact, when overlaying a modest allocation of gold to a balanced portfolio of stocks and bonds, it doesn't really matter what kind of product you use. Junior stocks, producers' shares and bullion itself all foster the same portfolio return. Only the risk undertaken is different.

A fund is only as "good" as its component stocks. There's a vast difference — along several dimensions — between the stocks making up the junior portfolio and those comprising the producer product.

By comparing the top five constituents of each portfolio, we can get a better sense of the internal forces at work.

By and large, there aren't real "standouts" among the top tier of gold producers. Most portfolio metrics, save for their Sharpe ratios, are fairly uniform. That shouldn't be too surprising for established companies.

But a couple of the metrics probably bear explanation.

Downside semivariance is the standard deviation of daily losses. It's often said that volatility is a two-edged sword: Upside moves are considered just as risky as downturns. Downside semivariance accounts for only the "bad" volatility. A skew in the semivariance metric from the stock's volatility midpoint gives an investor a better sense of the security's real risk. Note, for example, that the downside semivariance of Kinross Gold Corp. is more than half its annualized volatility. KGC was a stock more likely to have "down" days than "up days."

Sharpe ratios express a stock's risk-adjusted excess return; that is, its gains over a risk-free investment, factoring in its volatility. A ratio above 1.00 represents an excess return greater than the stock's risk.

Here, each stock's beta, or relative variance, is set against gold's. Positive readings indicate a directional correlation to bullion. A beta over 1.00 indicates the degree of excess volatility over gold's.

There's a lot more variability in the juniors' performance, which is reflected not only in the spread of returns, but also in their Sharpe ratios and betas. Clearly, China's SEMAFO, Inc. [TOR: SMA] was an outlier. Its beta may bear explanation, though; the number is so low because the stock tends to "zig" when gold "zags." In large part, this is a currency effect, as SEMAFO and Alamos Gold Inc. [TOR: AGI] trade in Canadian dollars.

Notably the junior miners' volatility, as well as their downside semivariance, is uniformly higher than that of the larger producers.

Taking a slice off the top, each miner group leaves us with this: Yes, you'll likely get a better return from juniors in a bull market for gold, but you'll pay for it with higher volatility and downside risk.

The question you have to ask yourself is whether you're nimble enough to lift your portfolio exposure to these high-speed stocks before they can have a deleterious effect.

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